Why Accounting Matters for Investors
Financial statements tell the story of a company's health. While you don't need to become an accountant, understanding the basics helps you:
- Evaluate whether a company is profitable and growing
- Assess the company's financial stability
- Compare companies within the same industry
- Identify potential red flags or warning signs
- Make more informed investment decisions
The Three Main Financial Statements
Balance Sheet
A snapshot of what a company owns (assets) and owes (liabilities) at a specific point in time.
Key question: How financially stable is this company?
Income Statement
Shows revenue, expenses, and profit over a period of time (quarter or year).
Key question: Is this company profitable?
Cash Flow Statement
Tracks actual cash moving in and out of the business.
Key question: Does this company generate real cash?
The Balance Sheet
The balance sheet follows a simple equation: Assets = Liabilities + Shareholders' Equity
Assets (What the Company Owns)
- Current Assets: Cash, accounts receivable, inventory - things that can be converted to cash within a year
- Non-Current Assets: Property, equipment, patents, long-term investments - things held longer than a year
Liabilities (What the Company Owes)
- Current Liabilities: Accounts payable, short-term debt - obligations due within a year
- Long-Term Liabilities: Long-term debt, pension obligations - obligations due beyond a year
Shareholders' Equity
The difference between assets and liabilities - essentially what would be left for shareholders if the company sold everything and paid all debts.
The Income Statement
Also called the Profit & Loss (P&L) statement, it shows whether the company made money over a period.
Key Components (Top to Bottom)
- Revenue (Sales): Total money earned from selling products/services
- Cost of Goods Sold (COGS): Direct costs to produce what was sold
- Gross Profit: Revenue - COGS
- Operating Expenses: R&D, marketing, administrative costs
- Operating Income: Gross Profit - Operating Expenses
- Interest & Taxes: Financing costs and tax payments
- Net Income: The "bottom line" - final profit after everything
The Cash Flow Statement
Profit on paper doesn't always mean cash in the bank. The cash flow statement shows actual cash movement, divided into three sections:
1. Operating Activities
Cash generated from the core business operations. This should be positive and growing for healthy companies.
2. Investing Activities
Cash spent on or received from buying/selling assets, acquisitions, etc. Often negative when a company is investing in growth.
3. Financing Activities
Cash from issuing stock, borrowing, paying dividends, buying back shares.
Important Valuation Metrics
| Metric | Formula | What It Measures |
|---|---|---|
| P/E Ratio | Stock Price / EPS | How much you pay per $1 of earnings |
| P/B Ratio | Stock Price / Book Value per Share | Price relative to company's net assets |
| P/S Ratio | Market Cap / Revenue | Price relative to sales (useful for unprofitable companies) |
| PEG Ratio | P/E / Earnings Growth Rate | P/E adjusted for growth |
| ROE | Net Income / Shareholders' Equity | How efficiently company uses equity to generate profit |
Red Flags to Watch For
Where to Find Financial Statements
- SEC.gov: EDGAR database has all public company filings (10-K annual, 10-Q quarterly)
- Company Investor Relations: Usually on the company's website
- Financial websites: Yahoo Finance, Google Finance, Morningstar
- Brokerage platforms: Most provide financial data for research
Tips for Reading Financial Statements
- Look at trends: Compare multiple years, not just one snapshot
- Compare to peers: Industry benchmarks matter - a 10% margin is great in grocery, poor in software
- Read the footnotes: Important details and risks are often buried there
- Start with the cash flow statement: Cash is harder to manipulate than earnings
- Be skeptical of non-GAAP metrics: Companies sometimes create flattering adjusted numbers
